El Niño planning ahead to manage risk

Daniel Fairweather, Divisional Director of Aquaculture and Fisheries at Willis, looked at the benefits of having El Niño insurance in a recent article on LinkedIn.

September 10, 2015

The El Niño Southern Oscillation (ENSO) is a climate event, where the adverse warming of sea surface temperatures in the Pacific Ocean leads to extreme weather conditions affecting weather systems and countries globally.
Climatic impact varies from extreme rainfall and flooding in some areas, to extreme droughts and high temperature in others.

From a food and feed perspective these changes can have devastating effects on industry, with farmers, fishermen and local industry and finance having to contend with extreme weather events leading to crop failure, rapid soil erosion, damage to industry and suboptimal conditions leading to outbreaks of disease. In the last severe El Niño in 1998, rainfall in Peru reached 40 times the average.

El Niño events occur roughly once every five to seven years and although they are relatively short in duration they can have far reaching and long lasting impacts on industries involved in animal and crop production. The chances of an El Niño event occurring this summer (2014) are currently estimated at 70%.

A clear impact of El Niño events can be seen in Peru and the impact on the Peruvian anchovy fisheries sector, producing the bulk of the world’s fishmeal. El Niño reduces anchovy spawning and leads to a change in migration patterns, typically causing huge disruption in the fisheries sector. In each year where El Niño occurred (1972, 1982 and 1997) huge reductions in anchovy catches resulted, and the near collapse of the industry was experienced.

As well as water temperatures affecting the migration and spawning of the Peruvian anchovy population, many Peruvian fishermen are at the mercy of the weather. These conditions often cause huge disruption to the fishing effort, increasing the costs of fishing and the ultimately the ability of the fishermen to repay loans.

With the increased costs of catching, coupled with reduced catches, the result is huge increases in fish meal prices.

Terrestrial Farmers
With the development of more and more plant based feeds for aquaculture, the effects of El Niño put pressure on some of the key grain and soy producing regions of the world. With ever increasing competition for land to supply feed for humans, biofuels and fodder crops any disruption to supply can have marked effects on raw material pricing. The 1997-98 El Niño severely affected the Southeast Asia and Oceania regions, leading to wide scale crops failures and huge increases in food prices which, in turn, resulted in sustained hardship for many across the region. Grain production in eastern Australia and the Philippines reduced dramatically, and the same is anticipated during the next El Niño event.

Feed manufacturers
Modern aquaculture feeds are increasingly dependent on ingredients coming from a number of suppliers, usually globally sourced, and typically using both terrestrial (grains or soybean) and marine (fish meal) suppliers. Consequently aquaculture feed producers are affected by most of the major effects of El Niño events. Increased raw material prices might be offset by passing these costs on to feed buyers, but by how much and for how long?

Fish Farmers
Fish farmers, as the end user in terms of aquaculture feeds, bear the brunt of increase in raw material price rises. Unless they have managed to secure long term contracts with feed suppliers, or avoided fixed price supply deals with fish markets, they are heavily exposed to feed price fluctuations. Feed prices make up a significant portion of the costs of fish production, and will erode profit margins unless prices are passed on to the consumer. This can sometimes be difficult to do when competing against wild fish supplies or substitute proteins. If alternative feeds are available, then these might be a short term option, however this tactic may result in sub-optimal nutrition leading to reduced growth rates and ultimately an inferior product.
What measures can be taken to mitigate against the effects of El Niño?
In all cases, irrespective of position within the supply chain, companies should take a pro-active approach to risk management. Risks should be identified, assessed and monitored.

Once the impact of these risks is analysed, strategies for reducing or managing these risks can be developed. Management steps can be as simple as substituting feed, to hedging the effects of El Niño events by purchasing specialist insurance.

What is crucial in all cases is to plan ahead. Many of the effects of El Niño will be felt throughout the market and will be affecting many stakeholders at the same time, so impacts will be significant throughout supply chains. Unless companies plan ahead they will have no option but to react as events unfold, in what will be a very dynamic environment. Decisions will have to be made under stress, and may result in less than optimal outcomes.

Some risks are completely out of the control of companies, but many are not, and those that can be controlled can either be managed through good business practice, or potentially transferred to the capital or insurance markets.

Advances in meteorological modelling and climatic monitoring have enabled the development of risk models to predict complex climatic events with ever greater accuracy. As these models have evolved, so have the options for dealing with the extreme events they signal. By using financial hedging and insurance products, the effects of climate shocks can be alleviated (from a financial perspective).

How can El Niño insurance help?

This product is highly innovative in a number of ways:
• It provides protection against the foreseeable increased cost of dealing with one of World’s most intractable natural hazards.
• Uniquely, it enables buyers to obtain protection and receive payouts prior to the El Niño event occurring. This allows opportunities for risk management and loss prevention ahead of the event.
• The basis of its operation is entirely formulaic and objective, supported by a reliable and recognized third party thereby reducing moral hazard and the potential for adverse selection.
• Claims payments are swift, avoiding lengthy, often contentious loss adjustment.

How does it work?

Sea Surface Temperature (SST) is measured (daily) at specified ocean locations in the equatorial Pacific and recorded by the United States National Oceanic and Atmospheric Administration (NOAA). The primary indicator of an impending El Niño event in Peru, for example, is the SST as measured in the specified ocean location referred to as ‘ENSO 1.2’ during November and December.

This index based insurance solution responds if the average SST during November and December as measured at ENSO 1.2 exceeds an agreed temperature threshold. If the trigger is breached, the agreed payout will be made.

The Insured does not have to prove that there has been any individual loss or damage; the breaching of the threshold is sufficient to trigger the payment.
Benefits of El Niño Insurance

There are a number of specific benefits to particular industries, but broadly speaking the main advantages for all policy holders are the following:

Transparency - What you see, is what you get – this inspires trust in the buyer – so long as they understand the basis risk

No on-site adjustments - Payments are only made according to the index, which avoids costly loss adjustment which requiring considerable expertise.

Lack of adverse selection / moral hazard - It doesn’t matter who buys the protection; the pay-out will be unaffected. If the business manages their risk badly they will not get paid more (or less) than the Index determines
Addresses correlated risks - Severe events, such as drought, can be well addressed by index-based products but they can be a challenge for conventional insurance

Low operational and transaction costs - As no individual underwriting is required, the cost of policy distribution, administration and claims handling can be minimised

Rapid payout - No further adjustment is required once the final level of the Index has been determined

Daniel can be contacted here.